One of the oft-asked questions in my Art of Investing Workshops is…
“How can a small investor create his circle of competence?”
This is a very important question, because “circle of competence” is in itself one of the most important facets of successful investing.
Anyways, tribesmen who have attended my Workshops (and I will let the secret out for tribesmen who are going to attend the upcoming Workshop in Mumbai :-)) know that my answer to this question is – Know your circle of “incompetence”.
Circle of incompetence?
First, let me touch upon on the meaning of “circle of competence”.
This concept, as popularized by Warren Buffett, states that investors should limit their investments to industries or areas where they know more than the average investor.
This is a very basic principle that simply says – don’t invest in what you know nothing about.
In other words, invest in only what you know.
Now, if someone asked me what my circle of competence is, I would find it very hard to answer, except that, in my experience as an analyst, I have studied companies from industries like technology, telecom, power, capital goods, automobiles, and FMCG.
I also know about these industries for I have been a consumer of their products and services for long.
But if you were to ask me about the oil and gas sector or pharma sector, while I have consumed fuel (for my car, of course) and medicines, I have no real clue about how a drilling rig works, how does crude oil looks like, or how do companies find new drugs.
I also don’t know what lies inside a bank’s balance sheet, or how to read balance sheets of real estate companies – simply because I don’t know what’s real in them and what’s fake.
In short, I have created for myself a circle of “incompetence” as far as industries are concerned.
Then, I don’t know how to deal in special situations, event-driven investing, cyclical stocks, or F&O. In fact, I have deliberately kept out of these given the high amount of stress involved for every unit of potential return.
These are thus also part of my circle of incompetence.
Now you may have a question – “Why create a circle of incompetence when creating a circle of competence seems easier?”
Well, this is because I find some intrinsic limitations to the circle of competence concept.
I am not so sure how a small investor, who is generally busy focusing on industries he already knows well – one he works for and a few whose products or services he consumes – can expand that circle of competence.
I also don’t know how a small investor can really prove to himself that he’s truly competent in a given area.
But when I read Charlie Munger reiterating Jacobi – Invert! Always invert! – I know there’s another way (then picking what you know) to create your circle of competence.
That way is to know things you don’t know and then draw a circle that keeps those things out.
First, know things you don’t know
This is very much what scientists do. They approach a problem and its solution by trying to prove it is false, not that it is true.
So, if you know things you don’t know – your circle of incompetence – you will automatically get to what you know – your circle of competence.
You may wonder, “Vishal, if I do what you suggest, I will be left with a very small circle of competence simply because I don’t know so many things!”
Well, in that case, it is important to remember what Warren Buffett wrote in his 1996 letter to shareholders…
Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence.
The size of that circle is not very important; knowing its boundaries, however, is vital.
How I draw my circles
Here is what I have started doing as far as my circles of competence and incompetence are concerned.
I don’t approach any company or industry from a position of confidence.
So, instead of saying, “Hey, I know this company and industry,” I tell myself, “Let me start looking at this company as if I don’t know anything about it, and thus study it deeply.”
Instead of thinking that I’m competent and “know everything” about a business, I start as being incompetent.
This thought-process helps me be mindful of the risks that a business may possess – a business where accidents may be waiting to happen.
Keep it simple
Charlie Munger says, “You don’t have to do everything well. At the Olympics, if you run the 100 meters well, you don’t have to do the shot put.”
So here’s what you can do to draw your own circle of incompetence…
- Take a list of companies – say the BSE-200 index .
- Start with creating your circle of incompetence by junking some businesses that you obviously don’t understand. Like for me, those are banking, pharma, oil & gas, commodities, and real estate.
- For rest of the businesses, pick up their latest annual reports, read them and then decide whether you are able to understand them or not.
- For a business you still don’t understand – what is the product or service, how does the company earn sales and profits, what are the broad opportunities and challenges, who are the competitors etc. – skip them as being part of your circle of incompetence.
- Don’t feel bad if your circle of incompetence is too big. Instead, feel happy that you won’t have to worry about all those businesses. 🙂
- For businesses you understand (simple businesses), add them to your circle of competence, and then use a basic excel model to do a deeper analysis.
The idea is to keep things simple.
Know the boundaries of your competence, and then look at things inside that circle.
Better still, know the boundaries of your incompetence, and then look at things outside that circle.
Basically, keep it simple, know the boundaries, and you will be fine.